Small firms need special incentives

Written by fe Bureau | Updated: Aug 15 2014, 07:01am hrs
Governments play a key role in fostering investment in R&D and innovation. Fiscal incentives to support business R&D is common among countries. Most countries provide fiscal incentives through tax credits or allowances and capital expensing. Some of these incentives can be emulated in India to support innovation.

According to OECD studies (Measuring Innovation: A New Perspective, and The OECD Innovation Strategy: Getting A Head Start On Tomorrow) in countries like Belgium, France, Korea and Spain, additional fiscal incentives are provided through reductions in R&D workers wage taxes and social security contributions. Austria provides both R&D tax credit and R&D allowances. Belgiums tax incentives include a deduction for patent income.

India is among the countries that provide a generous tax environment for investment in R&D (see chart, Tax Subsidy...) But it hardly makes a distinction between large and small industries in providing incentives. Empirical evidence shows that firms that are in the process of catching up with the technological frontier are particularly affected by corporate taxes. That means, corporate taxes may have a particularly negative effect on innovation incentives for catch-up firms by disproportionately reducing their after-tax return to innovation.

Tax policies targeted to small businesses, especially those engaged in innovative activities, include favourable depreciation rules for capital expenditures and reduced capital gains taxes after the initial public offerings of qualified small business stock.

Such targeted tax preferences may offset the high tax compliance costs relative to their size that small businesses face and are considered a more market-oriented approach (than direct support measures) for dealing with market failures and information asymmetries that might be particularly burdensome for young and often small innovative companies.

In many countries R&D tax credits are more generous for smaller firms (e.g. Belgium, Canada, the Netherlands, Norway and the United Kingdom), since the problems of asymmetric information that affect financing of R&D activities by banks or outside investors are likely to be particularly great for young innovative companies.

Some countries offer preferential tax treatment to young innovative companies (see box). These additional tax measures include immediate cash payment rather than use of carry-forward and carry-backwards provisions (Canada, France, Norway and the UK); and exemption from social costs for all researchers and technicians (Belgium and France). Within the European Union, governments can give extra incentives to firms less than six years old which spend more than 15% of their total revenues on R&D across all regions and sectors without breaking EU state aid rules.

Such direct subsidies may raise the marginal rate of return to R&D and relieve firms of (some) R&D and innovation costs, thus modifying their marginal cost of capital. In addition, direct R&D subsidies may also have positive indirect effects at the micro level. For example, in the case of small or young firms, government R&D funds may have a certification effect, thus lowering these firms external cost of capital.

One thing for the policy makers to keep in mind is that spending on innovation is more than spending on R&D. To develop new products or processes, firms invest in R&D and in other tangible and intangible assets. R&D usually accounts for around one-half to two-thirds of all innovation expenditure.

On average, firms tend to spend 1-2% of turnover on various innovation-related activities, but this share exceeds 5% for large firms in some countries.

OECD innovation surveys for 21 countries showed that firms receiving public support for innovation invest 40% to 70% more than those that do not. Also, higher levels of firms investment in innovation lead to higher innovation sales and productivity.

New and young firms play an important role in innovation, as they often exploit technological or commercial opportunities that have been neglected by more established companies.

Another point to remember is that innovation requires sound framework conditions and policies that facilitate innovation in general and the start-up and growth of new firms. Well-functioning product, labour and financial markets and openness to domestic and international competition are also vital.

A 2005 study found that stable macroeconomic conditions and low real interest rates help encourage the growth of innovation activitythings which India lacks at the moment. Factors that help lower the level of real interest rates can stimulate innovation because of the impact on the user cost of R&D capital.